Phil Young: Why I’m troubled by P2P lending

I am open minded, but peer-to-peer lending troubles me and there are a few myths and rumours which need debunking:

You do not have to advise on it to be independent

While peer-to-peer lending is FCA-regulated it is not a retail investment product, so you do not need to advise on it to remain independent.

Should you remove permission?

We do not really know where any of this will go in future. It could end up covered by the Financial Services Compensation Scheme. There is already an innovative finance Isa and talk of allowing it into pensions. So it is advisable for investment firms not to remove the permission as you will only have to pay to add it on later should you wish to advise in this area. Insurance-only firms not intending to get involved in peer-to-peer business should consider removing this new permission as keeping it will have an impact on financial resource requirements and regulatory fees.

Check your PI

Professional indemnity insurers are wary of this right now as it is a niche market with little track record as an advised investment. If you want to advise in this area check it is covered and what the excess will be.

What are insurers worried about?

Peer-to-peer is not an evil product per se, there is just a risk that a significant number of advisers will offer this as an alternative for cash, select the highest rate not the most stable platform, and prompt a wave of complaints when it does not go to plan.

What is often referred to as a “toxic” product is more a combination of factors leading to a high volume of complaints which taints the rest of the market.

It is not cash, but…

In my experience, the people looking at peer-to-peer as an investment are not selling down equities, they are investing from cash. These are people not wanting the “risk” of equity markets, but looking for a higher return than cash. As the headline attraction is the rate, it is hard not to anchor our understanding of peer-to-peer lending to cash.

“More risky than cash, but less risky than equities.” That is how it is marketed and reported on in the press. It appears less volatile, for the reasons stated below, and for many people volatility equates to risk. However, risk to capital could be considerable, and Lord Adair Turner has already warned of irresponsible lending in anticipation of huge losses among peer-to-peer lenders. FCA chief executive Andrew Bailey also expressed concerns around this new market.

The dangers of suck it and see

Using Ratesetter and Zopa looks and feels like investing in a fixed interest paying deposit account. The protection funds smooth out regular investment returns so you get the same return each month. Bad debt is chased down behind the scenes, giving the impression that there is no bad debt at all, unlike equity markets, where a daily price gives a very visible indicator of the ebb and flow of equity markets. A false sense of security which could lead to overconfidence and overexposure.

The future for this market, and its conflict of interest

My guess is the UK market can only go one of two ways:

Investment returns will continue to drop as the drive towards greater professionalism, security and regulation will force costs up at the expense of sizzling headline returns. This will curb exponential growth but avoid any high profile disasters.

It will grow exponentially as a low interest rate environment drives demand for better returns than cash. There could be a boom in new lenders, who have to take on riskier debt to satisfy demand. This means more bad debt, failures, and a decline in confidence.

Fundamentally, there can only be a finite number of people in the UK needing to borrow, who have a good enough credit rating to be trusted but not good enough for a bank to lend to. I do not know how big that market is, but this seems like a crucial question. Either the market must cap itself at a certain level, or accept more risk to keep growing.

There is an inherent conflict of interest in running a peer-to-peer platform that relies on satisfying both investors and borrowers, which can lead to a less sceptical approach than lending your own money.

How does it fit in with financial planning and investment theory?

How does it fit into an investment philosophy? Is peer-to-peer an asset class? How does it diversify a portfolio, and which other asset classes does it not correlate to? It is a bit too early to reliably assess how it performs under different, stressed market conditions.

Tax structures such as venture capital trusts and enterprise investment schemes do not fit neatly into a mainstream investment philosophy either, but can point to the tax advantages of such schemes as the main reason for taking on what might otherwise be an unacceptable level of risk. For now, I can see the attraction to direct investors, but I am not sure this is ready for the adviser market just yet.

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19th March 20182:18 pm

Comments

There are 14 comments at the moment, we would love to hear your opinion too.

As someone who has used ZOPA to borrow money (for a car loan) I would like to correct Phil (& others) who believe that the target market are “borrowers with a good enough credit rating to be trusted but not good enough for a bank to lend to”. Most of the banks who are advertising ultra-low interest rates do as as long as you want to borrow at least £7,500, but if you want to borrow less, the rate suddenly increases by a considerable margin.
This was my experience – my existing bank and another lender would have been quite happy to lend to me at just under 4%, as long as I wanted at least £7,500. I only wanted £5k though as I was topping-up my own funds, at which point the rates on offer were suddenly increased to north of 7%! I then went to ZOPA who were prepared to lend me the funds I needed at 5%.
I feel that there are probably a lot of Grade A borrowers who could (and probably are) borrowing smaller sums at lower rates than the banks are prepared to offer for these lower value loans.

An interesting article but it contains the assumption that P2P borrowing is targeted at individuals without access to bank lending.

“Fundamentally, there can only be a finite number of people in the UK needing to borrow, who have a good enough credit rating to be trusted but not good enough for a bank to lend to. I do not know how big that market is, but this seems like a crucial question.”

I don’t recognise this. P2P is successfully competing (on both rates and service) with high street banks for creditworthy customers and long may it do so.

Fair points both, let’s see how the market develops, and the banks really do need a kick up the bum – I’m all in favour of that. Interest in comments on my concerns around this from an investment perspective though – I’m happy to admit I’m not an investment theory expert.

Phil, many P2P lenders beat the rates on the comparison sites & are competing head on with traditional banks and winning for borrowers with good credit ratings. P2P loans don’t normally have early repayment penalties and are quicker and more flexible. The idea that P2P only lend to people or businesses with poor credit ratings isn’t supported by evidence. Take a look and see for yourself. The market for P2P is as big as the loan market is.

I can’t agree that “It is a bit too early to reliably assess how it performs under different, stressed market conditions”. Having researched this area extensively, there’s an enormous amount of data to evidence it produces more stable yields without volatility than more or less any other asset class you’d find in a typical stochastic projection tool. In the UK, Zopa data goes back to 2005, through just about the biggest stress test & ‘credit cycle’ we’ve known. Bank of England data for comparative unsecured credit card lending shows not a single yr of negative yield since 1999, with avg yield ~6.4%. Comparable US data goes back to 1995, showing avg yield of 8.2%. (Source: Liberum). Show me one other asset class with that track record & lack of capital volatility through the dot com bubble bursting & the credit crunch? Compare that to the volatility of gilts, the huge volatility of equities or suspended property funds through the same period.

I don’t understand your ‘conflict of interest’ point. If P2P lenders take on more risk than they should, their default and yield returns data (transparently reported via AltFi) will show poor performance, investors will move their money and their shareholders will be affected as a result. By comparison, banks have a history of lending to high risk clients to increase profits for shareholders, having to get bailed out by the government but still not passing on the benefits to their savers? In P2P the fees are transparent & investors directly reap the rewards.

The market is evolving fast and excellent sources of data, training, CPD, etc are becoming available. I strongly believe that P2P will become an important asset class for intermediaries to use as part of a carefully balanced portfolio.

Would you care to elaborate on what asset classes this ‘important asset class’ doesn’t correlate to and why? Are you suggesting that other asset classes don’t have a 10 year history, and this one has a long track record based on one business being in existence in 2005?

I am really supportive of the growth of P2P and its variants. It has a bright future.

However, I would not encourage clients to deposit money with them and at some point there will be some implosions as the regulations are not stringent enough and there will be something which blows-up and goes totally wrong and then I don’t want the FSCS to be the bail-out and to find we are having to support that…! I suppose, by all means borrow as the credit is flowing the right way…!

At AltFi we have visibility over every cash flow relating to every loan originated by the UK’s 4 biggest P2P lenders that together make up c.70% of the UK market. We can use this un-precedented disclosure to provide real time visibility into the state of their loan books. This creates alignment with investors as if loan performance deteriorates then investors will cease funding loans, immediately impacting platform revenues. This creates a very powerful incentive for the platforms to post high quality and well priced loans.
This data also allows us to represent the net return track record of the sector as represented by the LARI returns index. http://www.altfi.com/data/indices/returns
The sector can now demonstrate over 10 years of stable and impressive returns. We offer even more granular data and analysis in our AltFi Data Analytics tool. https://youtu.be/wXx660LqHTc
We would therefore disagree with the idea of a conflict of interest and also highlight the extensive track record that this asset class has now established. We are hopeful that we can use this data to encourage adoption and help advisors to prove suitability allowing them to recommend this product.

If I lend money I want collateral. Unsecured lending is best done by banks and recognised financial institutions who ensure that that the money can be repaid. P2P relies on a set percentage of defaults and we have already seen failures in the sector and also censure for others by the regulator. This is a cess pit both for those who borrow and those who lend. Follow the wise Shakespear “Neither a borrower, nor a lender be;For a loan oft loses both itself and a friend” (Hamlet). Wise indeed!

I think the biggest issue for advisors is understanding what falls under the Peer to Peer headline and how to tell platforms apart.
– platforms offer different types of lending unsecured personal and business, invoice finance through to secured property and SME loans. These are very different asset classes.
– different platforms operate different P2P models from the ‘time deposits’ through to vanilla Peer to Peer, where the investor has full information transparency and choice of who they make loans to
– some platforms cater for active investors, some for passive investors
– some platforms offer the right to receive interest which is a different instrument from P2P
– does the platform have a provision fund and does that ‘actually cover’ when something goes wrong
– most platforms have some sort of loan grading / risk system symbolised by numbers, letters or symbols. How can you tell if a three shield on one platform is comparable to a three buckets on another
The learning curve for both Investors and Advisers is very steep and a potential huge barrier to entry.

Harry: if you want collateral that’s fine, just look at the range of P2P lenders offering secured loans.

Phil: take a look at the excellent analysis from Liberum on online direct lending (ODL) vs other UK & US asset classes, then you’ll see. The main difference is that with portfolios of P2P loans yields vary depending on defaults, but you don’t get the capital volatility associated with other asset classes. Take a look at the AltFi data to.

I’d like to invite you both to be adviser panellists at our free conference on 1st Nov in London then you can see the evidence presented by the companies above first hand & we can discuss – up for it?

This makes little sense to me. If someone has decent collateral why go P2P at all? Banks would welcome them. As I see it people go P2P who are not credit worthy enough to get a loan from a conventional source. Those borrowing small amounts are (by my definition) not very credit worthy anyway. The obviously don’t have recourse to their own savings for emergencies.

This is not a criticism of them personally. I fully understand why some people need P2P and the gap that this service provides. It is just that In don’t see it as a viable investment either for me or for private clients. Those with money they can afford (or are willing) to loose may well dip their toes into these waters. For the serious investor however the conventional avenues still look more appealing and a certainly that as far as advisers (who value their PII) are concerned.